Category: Blog

President’s Working Group (“PWG”) on Financial Markets issued the long-awaited Report on Stablecoins on Monday, November 1, 2021. It is not entirely surprising that PWG focused their efforts on stablecoins – digital assets, the value of which are pegged to the traditional currency, – undeniably a low-hanging fruit in the crypto ecosystem. Certain stablecoins generated negative publicity earlier this year, when findings were published about the reserved asset composition, which revealed that not every token was backed 1:1 by USD or US Treasury bills. Instead, some held a high percentage of riskier assets in their reserves (i.e., other digital assets, commercial papers, corporate bonds, and others). 

The report acknowledged the proliferation and importance of stablecoins. In addition, it provided comprehensive coverage of the asset’s use cases, including vital importance to DeFi activities, such as lending, borrowing of other digital assets, trading, store, and transfer of value, all of which arguably would reduce the need for the traditional financial institutions. 

PWG identified the following risks related to stablecoin usage, which the regulators consider to be inadequately addressed “due to the lack of consistent risk-management standards among arrangements, the number of different key parties that may be involved in an arrangement, and the operational complexity of an arrangement”: 

• Loss of value and stablecoin run risk, where lack of performance “according to expectations” would result in a “run”, defined as a “self-reinforcing cycle of redemptions and fire sales of reserve assets.” Prudential standards absent, risks to the broader financial system “could rapidly increase as well,” the report states. 
• Payment systems risks, which essentially include all of the same risks that users in the traditional financial system are exposed to: credit risk, liquidity risk, operational risk, risks arising from improper or ineffective system governance, and settlement risk. However, because of the decentralized nature of many stablecoins, it is unclear who and what manner should be responsible for risk management. 
• Operational risk, where “deficiencies in information systems or internal processes, human errors, management failures, or disruptions from external events” would result in the overall breakdown or deterioration of services. The regulators point out that “operational issues in a payment system can disrupt the ability of users to make payments, which can in turn disrupt economic activity.” 
• Settlement risk, which means that a payment would not settle as expected. Because stablecoins lack clear definitions with respect to when the settlement should be considered final, credit and liquidity pressures for transaction participants the finalization of the settlement “heightened uncertainty and create credit and liquidity pressures for arrangement participants.”
• Liquidity risk, which can arise as a result of operational misalignments between stablecoins and traditional systems, “causing temporary shortages in the quantity of stablecoins available to make payments.” 
• Risks of scale, including systemic risk and concentration of economic power, which could “have detrimental effects on competition and lead to market concentration in sectors of the real economy” due to the lack of competition. 

Because stablecoins are not subject to a “consistent set of prudential regulatory standards” that would address and mitigate the risks outlined above, PWG suggests the following: 

• Limit stablecoin issuance to entities that are “insured depository institutions” (i.e., banks) and prohibit others from doing so. As a result, “stablecoins would be subject to supervision and regulation at the depository institution level by a federal banking agency and consolidated supervision and regulation by the Federal Reserve at the holding company level.” This would address the user protection and run risks. 
• Subject custodial wallet providers to appropriate federal oversight, including “authority to restrict these service providers from lending customer stablecoins, and to require compliance with appropriate risk-management, liquidity, and capital requirements”. That would address payment system risk. 
• Further, any “affiliation with commercial entities” and use of transactional data should be limited. In addition, supervisors should have the ability to adopt standards to promote interoperability among stablecoins, or between stablecoins and other payment instruments. That would address the systemic risk and concentration of economic power. 

The regulators urged Congress to issue the relevant regulations as soon as possible. They also noted their continuing efforts at the FATF “to encourage countries to implement international AML/CFT standards and pursue additional resources to support supervision of domestic AML/CFT regulations.” 

The issue at stake (pun intended) is whether a gain or loss should be recognized when assets are staked in or staked out.

Author: Olya Veramchuk, Director of Tax Solutions in Tax & Regulatory Affairs

FATF issues updated guidance for a risk-based approach for virtual assets and virtual asset service providers

The Financial Action Task Force (“FATF”), the global money laundering and terrorist financing watchdog, kicked off October 28, 2021, by issuing the updated guidance for virtual assets (“VAs”) and virtual asset service providers (“VASPs”). The earlier version of the report was issued in spring 2021 and was criticized by many industry participants for being too broad and unclear. The new iteration of the report forms part of the FATF’s ongoing monitoring of the virtual assets and VASP sector, offers long-awaited clarifications and comments on DeFi protocols, NFTs, stable coins, travel rule application, and more. 

For better or worse, the document is long and FATF intends for the definitions to be applied broadly. High-level highlights of the new guidance are outlined below.   

1. VAs are defined as “a digital representation of value that can be digitally traded or transferred and can be used for payment or investment purposes. Virtual assets do not include digital representations of fiat currencies, securities, and other financial assets that are already covered elsewhere in the FATF Recommendations.”  

Notably, non-fungible token (“NFT”) collectibles weren’t explicitly included in the definition of virtual assets. However, in the event an NFT is used for “payment, investment purposes” or as a value transfer, then it would likely fall under the VA umbrella. FATF suggests that the regulators apply a “functional equivalence and objective-based approach” when in doubt, encouraging understanding assets’ functionality and purpose.  

Further, FATF lowered the threshold amount for VA-related transactions to USD/EUR 1,000 due to the money laundering risks “associated with, and cross-border nature of” virtual asset activities. 

2. VASPs are redefined to ”any natural or legal person that conducts one or more of the following activities or operations for or on behalf of another natural or legal person:
   • Exchange between virtual assets and fiat currencies;
   • Exchange between one or more forms of virtual assets;
   • Transfer of virtual assets;
   • Safekeeping and/or administration of virtual assets or instruments enabling control over virtual assets; and
   • Participation in and provision of financial services related to an issuer’s offer and/or sale of a virtual asset.

Depending on their particular financial activities, VASPs include “VA exchanges and transfer services; some VA wallet providers, such as those that host wallets or maintain custody or control over another natural or legal person’s VAs, wallet(s), and/or private key(s); providers of financial services relating to the issuance, offer, or sale of a VA (such as in an ICO); and other possible business models”. 

Interestingly, multi-signature wallets where “a person maintains unilateral control of their assets at all times” seem to not be covered by the VASP umbrella. But only as long as it doesn’t “actively facilitate” the transfer. Unfortunately, no explanation as to what “active facilitation” would mean was provided. 

3. No concrete clarification is provided with respect to DeFi protocols. The guidance introduces the concept of owner vs. operator and remarks that anyone with “sufficient influence” of a protocol would rise to the level of a VASP. It is unclear how one would define how much influence would rise to the level of being “sufficient” or how that should be measured. 

4. Stablecoin issuers with a “central developer or a governance body” which handles the basic management functions, including “development and launch of” a stablecoin, would likely be classified as financial institutions or VASPs. 

5. FATF is particularly concerned with the peer-to-peer transactions carried out via self-hosted and unhosted wallets, as in their view such transactions pose a heightened risk of money laundering. This is because “illicit actors can exploit the lack of an obligated intermediary in P2P transactions to obscure the proceeds of crime because there is no obliged entity carrying out the core functions of the FATF Standards.” Risks could be mitigated in the following ways:
   • Conducting outreach to the private sector;
   • Training of supervisory, financial intelligence unit and law enforcement personnel; and
   • Encouraging the development of methodologies and tools, such as blockchain analytics, to collect and assess P2P market metrics and risk mitigation solutions, risk methodologies to identify suspicious behaviour, and determine whether wallets are hosted or unhosted, including by engaging with programmers/developers in this space.

6. The travel rule requirements were expanded: VASPs are now expected to ensure disclosing and transferring certain customer data as part of each digital asset transaction, but robust due diligence with respect to the counterparty VASP is required before the information is remitted. This is because VASPs which do not implement the travel rule would be considered higher risk. Transactions should be screened on the ongoing basis to ensure that no sanctions were levied on the counterparty to the transaction. Notably, FATF clarified that the travel rule would not apply to transfers between a VASP and an unhosted wallet, thus taking the fees paid to validators and miners out of scope. 

It is worth remembering that FATF guidance is not binding and does not override the views of the national authorities. However, the organization has its ways of applying pressure on non-compliant members, including blacklisting them. Undoubtedly, the next few weeks will be extremely interesting, as the guidance gets dissected and digested by global regulators and market participants alike.

The information contained in this bulletin provides only a general overview of current issues and shall in no event be construed as the rendering of professional advice or services. As such, the information provided in this bulletin should not be used as a substitute for consultation with professional advisors.  Before making any decision or taking any action regarding your digital currencies or the tax treatment thereof, you should always consult with an appropriate, licensed tax, accounting, or other professional. To the fullest extent permitted by law, in no event will Lukka, Inc. (including its related entities, owners, agents, directors, officers, advisors, or employees) be liable to any reader of this bulletin or anyone else for any direct, indirect or consequential loss or loss of profit arising from the use of this bulletin, its contents, its omissions, reliance on the information contained within it, or on opinions communicated in relation thereto or otherwise arising in connection therewith.